Water scarcity has been increasing around the world due to both demand and supply side factors, in particular population growth and climate change. Even in the U.S. states are experiencing water shortages and these problems seem likely to expand in the future, particularly in the southwestern United States. With future supplies in question and projected demand increases it is natural to wonder if current water use patterns are efficient.
When it comes to water use in the United States, it seems likely that the current allocation is not efficient. Markets determine efficient allocations through the price system, although in the presence of externalities or other market frictions, such as subsidies to a particular use, market prices may not correspond to an efficient allocation. In the case of water, different uses usually face differing price schedules and block pricing schemes are prevalent. North American water utilities generally set prices below the long run marginal cost of supply, which is the efficient price. Thus it is standard for a large fraction of publicly supplied water deliveries to be priced below the efficient price, which should to lead to overconsumption of water on a micro level.
At the macro level there are additional factors that would lead us to believe that the current water allocation is inefficient. Transfers, especially between states, are naturally limited by existing linkages and the feasibility of infrastructure investments. Even when transfers are possible, withdrawals and trades are often restricted by international treaties, regional compacts and Federal court mandates. The combination of inefficient pricing schemes and extra-market restrictions on withdrawals and transfers suggests that the current water use regime is distorted from an efficient one.
To better understand the nature of water misallocation, we will want to determine its magnitude, location and sectors and calculate the economic cost of any misallocation that is present. To achieve these goals this paper integrates water as a factor of production in a stylized neoclassical macroeconomic model. The water-input model incorporates the three primary consumptive uses of water, industrial, agricultural and non-market, as separate sectors of production and types of consumption. Water is storable across time, but not transferable between regions, with the balancing of non-monetary valuations of water against water’s value as a productive input driving storage decisions. The social planning version of this water-input model is the bench mark efficient allocation to which the data and alternate scenarios are compared to when computing economic costs.
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The Macroeconomic Cost of Water Misallocation in the U.S.
